Portfolio Changes: Looking More Like The Market

by: Roger Nusbaum

A big building block to the way I manage portfolios is trying to build the portfolio to have certain top down characteristics and then to change those characteristics as market circumstances dictate. There are a couple of reasons for this. One is that if I understand how the portfolio behaves then it becomes easier to know how to change the make up of the portfolio--like knowing that a certain name will make the portfolio more volatile when I want more volatility.

Another important reason is so that I can explain to clients why the portfolio is doing what it is doing at a given moment. We have always been heavy in foreign exposure for long term reasons that I have written about in hundreds of other posts. Last year was the first year since I have been at Your Source Financial where foreign lagged domestic badly and so we lagged the SPX last year. The divergence between foreign and domestic was unusually wide, being heavy in foreign has worked out over the long term but not so last year. While anything can happen in any given year it is unlikely, in my opinion, that foreign will lag domestic by that much anytime soon; obviously I think foreign will dramatically outperform over time.

But in terms of understanding the long term objective of the portfolio, the next time foreign does lag domestic like it did in 2011 then I would expect our portfolio to lag again. Most of the time owning foreign has been correct year to year but nothing can be right every single year and understanding this ahead of time makes it easier to navigate the cycle and to remember the long term objective - it is the long term that is our focus.

For most of 2011 I would say we did not look much like the S&P 500, we had a lot of cash and a lot of foreign. In the last few months I've disclosed four trades executed for "large" accounts (large accounts defined as being big enough where using mostly individual stocks makes economic sense for the client); we sold a small position in an inverse index fund and then we bought KLA Tencor (NASDAQ:KLAC), ASX Limited (OTCPK:ASXFF) and the Global X Fertilizer ETF (NYSEARCA:SOIL).

The objectives with these trades was to increase net long exposure to look more like the SPX to capture what I thought would be a good start to the year for the SPX (this is the range busting rally theme I've written about a few times) and to capture what is looking like a snap back move for certain market segments that did poorly last year.

We still have a fair bit of cash but with four trades we've gone from what I would say was not looking much like the market to looking a lot more like the market, which was an objective. This is not intended to brag about a result because among other things the time frame is too short to mean anything to clients. The intention of the post is to stress the importance of understanding the portfolio and then to understand how changes are likely to impact the portfolio.

Had one of the new additions gone to zero the day after we bought it then obviously this would have been a different type of post but one thing to understand about something new that you buy is how it trades. I mentioned the other day the extent to which Caterpillar (NYSE:CAT) gets crushed when the market goes down a lot (because of recession). The next time there is recession CAT will get crushed and the typical tobacco stock will hold up pretty well. Those two are simple ones while some others might not be so simple. When I disclose a new purchase I usually include some mention of how I expect it to trade and influence the portfolio.